For all the seven long years since the signing of the Maastricht treaty
started Europe on the road to that unified currency, critics have warned
that the plan was an invitation to disaster. Indeed, the standard scenario
for an EMU collapse has been discussed so many times that it sometimes
seems to long-time eurobuffs like myself as if it has already happened
- perhaps because it is modeled on the real crisis that afflicted the European
Monetary System back in 1992.

Here's how the story has been told: a year or two or three after the
introduction of the euro, a recession develops in part - but only part
- of Europe. This creates a conflict of interest between countries with
weak economies and populist governments - read Italy, or Spain, or anyway
someone from Europe's slovenly south - and those with strong economies
and a steely-eyed commitment to disciplined economic policy - read Germany.
The weak economies want low interest rates, and wouldn't mind a bit of
inflation; but Germany is dead set on maintaining price stability at all
cost. Nor can Europe deal with "asymmetric shocks" the way the United States
does, by transferring workers from depressed areas to prosperous ones:
Europeans are reluctant to move even within their countries, let alone
across the many language barriers. The result is a ferocious political
argument, and perhaps a financial crisis, as markets start to discount
the bonds of weaker European governments.

Well, here we are, right on the brink of the creation of "euroland",
and it is now clear that none of the problems EMU critics have warned about
will arise, at least for a while. Indeed, it turns out that Murphy was
wrong: not everything that can go wrong, does. Unfortunately, the remainder
of the revised law states that things you never imagined could go wrong,
will - and that is what is happening in Europe right now. Instead of the
expected fight between hard-nosed Teutons and dissolute Latins, what is
shaping up is a conflict between euroland's central bankers and left-of-center,
reflation-minded governments all across the zone - with the most unreconstructedly
leftist, most aggressively reflation-minded of these governments being
that of, yes, Germany.

But let's back up a bit, and recall the fundamentals of EMU. Never mind
the question of whether a unified currency is a good economic idea: EMU
has always been more about political symbolism than strict economics. But
while the ultimate if rarely acknowledged purpose of a unified currency
is to move Europe toward the long-run goal of political union, at this
point euroland is anything but ready to think of itself as a nation. After
all, the countries cannot even agree on a set of heroes to celebrate on
their currency: where almost every money in the world bears the portraits
of great men and women, the new euro notes will bear pictures of bridges,
gates, and windows - not any actual bridges or gates, mind you, but imaginary
bridges and gates that might come from any European country. (There was
a minor scandal a few months ago when it turned out that one of the pictured
bridges was actually, mein Gott, recognizably French. It was quickly
replaced with something acceptably generic).

But how do you run a common currency without a common government?

Europe has some experience with this sort of thing. For almost two decades
- since the formation of the European Monetary System in 1979 - most European
nations have committed themselves to maintaining fixed exchange rates between
their currencies, which basically means adopting a common monetary policy.
And while there have been occasional flareups in the arrangement - a last-gasp
attempt by the French to follow their own path back in 1982, and a wave
of speculative attacks that pushed Britain out of the system a decade later
- the EMS has proved surprisingly durable. How did Europe manage to follow
a common monetary policy? The was a bit of neatly calculated hypocrisy.
Athough the EMS was in principle a symmetric system, with all countries
treated equally, in practice it was tacitly run as a German hegemony: the
Bundesbank set interest rates as it pleased, and other central banks then
did whatever was necessary to keep their currencies pegged to the Deutsche
mark. This arrangement allowed the system to meet two seemingly irreconcilable
demands: the insistence of Germans, who still remember both the hyperinflation
of 1923 and the economic miracle that followed the introduction of a new,
stable currency in 1948, that their beloved Bundesbank keep its hand firmly
on the monetary tiller; and the political imperative that any European
institution must look like an association of equals, not a new, um, Reich.
The Europeans, they are a subtle race.

But come actual monetary union, this subtlety will no longer work, because
a truly unified currency must have someone - a European Central Bank -
explicitly in charge. How could this institution be set up to give each
country an equal voice, yet satisfy the German demand for assured monetary
rectitude?

The answer was to put the new system on autopilot, pre-programming it
to do what the Germans would have done if they were still in charge. First,
the new central bank - the ECB - would be made an autonomous institution,
as free as possible from political influence. Second, it would be given
a clear, very narrow mandate: price stability, period - no responsibility
at all for squishy things like employment or growth. Third, the first head
of the ECB, appointed for an eight-year term, would be someone guaranteed
to be more German than the Germans: Wim Duisenberg, who headed the Dutch
central bank during a period when his job consisted almost entirely of
shadowing whatever the Bundesbank did. Finally, just in case governments
should be tempted to use their control over taxing and spending to challenge
the ECB's grip over monetary policy, Germany insisted on a "stability pact"
that limited the ability of euroland governments to run budget deficits.

And so there it was, a neatly wrapped-up package, ready for delivery
on 1 January 1999. But a funny thing happened on the way to EMU: Europe's
economic and political complexion changed, and the biggest change came
in Germany itself.

The first sign of change came in France. Once upon a time France was
famed for its addiction to deficit spending and over-optimistic monetary
policy. By 1997, however, having weathered the crises of 1992 and 1993
without any devaluation of the franc, the French appeared to be as devout
in their worship of sound money as the Germans. Then came the election
of June, which was won by Socialist Lionel Jospin, a man who promised to
bring down unemployment. And as one of its early moves the new government
suddenly reopened the supposedly settled issue of who would head the ECB,
putting up Banque de France head Jean-Claude Trichet as its preferred candidate.
After a confused interlude, the confrontation ended with the agreement
that Mr. Duisenberg would indeed head the ECB, but Duisenberg either agreed
or didn't agree (I can't seem to get it straight - they really are subtle,
these Europeans) to resign in favor of Trichet half-way through his term.

Now the French left is not what it used to be. Jospin's government has
actually been quite careful and prudent in its spending policies, and has
not tried to assert any monetary independence. Nor is there any discernible
substantive difference between Trichet's views on policy and Duisenberg's.

But Jospin's victory, it turned out, was only a forerunner of the big
event: the defeat of Germany's Helmut Kohl, arguably the most important
architect of the new Europe, by Gerhard Schroeder's Social Democrats. The
symbolism of this win was powerful, because it meant that - thanks to the
usual Byzantine political intrigue in Italy, but as a result of voter disenchantment
with conservatives elsewhere - all of Europe's big countries, including
the UK (which is outside euroland for the moment, but still exerts a lot
of influence) are now governed by left-of-center parties. And the German
left, it turns out, *is* what it used to be - indeed, the governing coalition
now includes the Greens, adding a tinge of true radicalism. The people
who now rule Germany have no patience with the Maastricht ideology, which
says that all good things come to those who have balanced budgets, sound
money, and flexible markets. Schroeder's chief economic official Oskar
Lafontaine, in fact, sounds not like a German but like an old-style French
socialist: he has many doubts about free markets, might even consider rolling
back some of the moves made in recent years toward more flexibility in
things like wages and working hours - and he definitely wants reflationary
monetary and fiscal policies.

And he is probably half right. Not about free markets: Germany's markets,
though freer than they used to be, are still ludicrously overregulated
by U.S. standards; the modern German economic miracle is the fact that
given the level of wages, benefits, and regulation there are any jobs left.
But even those of us who do believe in supply and demand are a bit perplexed
by European monetary policy. Over the last few years the inflation rate
in euroland has been steadily dropping, normally a clear indicator of excess
capacity in the economy; over the last few months consumer prices in both
Germany and France have actually been falling. Euroland as a whole has
double-digit unemployment, and growth, after a couple of fairly good years,
is slowing as the continent feels the backwash from the world financial
crisis.

The actual situation as EMU begins, then, is nothing like the way we
all imagined it. Instead of an "asymmetric" economy, in which some countries
want tight money while others want a boost, the whole zone is a prime candidate
for lower interest rates - and all of the major governments agree that
the central bankers should emulate (EMUlate?) that wild and crazy guy Alan
Greesnpan, and loosen up. So there is, in the end, no conflict of interest.
Indeed, EMU could get off to a rousing start by cutting interest rates
and making everyone happy.

But EMU wasn't designed to make everyone happy. It was designed to keep
Germany happy - to provide the kind of stern anti-inflationary discipline
that everyone knew Germany had always wanted and would always want in future.
So what if the Germans have changed their mind, and realized that they
- along with all the other major governments - are more worried about deflation
than inflation, that they would very much like the central bankers to print
some more money? Sorry, too late: the system is already on autopilot, and
no course changes are permitted.

Of course, that isn't literally true. There is no fundamental reason
why the Bundesbank couldn't have given Mr. Duisenberg a housewarming gift
in the form of a late-year interest rate reduction; nor is there anything
in the ECB charter that would keep him from celebrating his new job by
throwing an interest-cutting party. So many economists are tearing their
hair out wondering why it isn't happening. But we must remember that the
whole point of the setup was to create an institution that can say no,
that will not give politicians what they want. To say yes, to give the
politicians what they want even if what they want is entirely reasonable,
feels like a betrayal. In fact, the more the politicians demand action,
the more the central bankers dig in their heels.

So what do the europessimists - the people who believe that the whole
experiment will come to grief - say now? Well, they have a new argument.
Pretty clearly, Europe is not about to tear itself apart because it cannot
agree about monetary policy. In fact, everyone but the central bankers
now *does* agree about monetary policy. The clear and present danger is,
instead, that Europe will turn Japanese: that it will slip inexorably into
deflation, that by the time the central bankers finally decide to loosen
up it will be too late.

These Europeans, they are a subtle race. And this time they may have
subtled themselves into a very tight corner.